Stephen King: New year, new uncertainties for global economy

The most obvious threat to the forecasters' consensus is the US current account deficit

Tuesday 4 January 2005 00:00 BST

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It's that time of year. The time to be looking ahead, thinking about the risks that might upset the forecasters' apple cart. It's a rare year indeed when the consensus forecasts prove to be totally accurate. In some years, the growth forecasts will be about right but the inflation forecasts wrong. In other years, we will see the reverse. In still other years, forecasters get growth and inflation right, but are unable to spell out the implications for interest rates, exchange rates and stock markets.

None of this will surprise you. The world is anuncertain place for economists. The best we can do is build theories from limited information. We can be quite good at saying, in hindsight, why a particular theory did not work out so well. We are not so good, in advance, at spotting the potential banana skins, the events and relationships that may find us lying flat on our faces before the year is out.

The most obvious threat to the forecasters' consensus is the US current account deficit. The problem here is twofold. First, it's quite likely that the deficit will get a lot bigger: with the consensus still expecting decent growth in the US but feeble growth in the eurozone and Japan, it seems inevitable that the deficit will head towards 6 or 7 per cent of GDP in coming quarters. Second, if the deficit does get a lot bigger, markets will increasingly wonder how it will be funded. In turn, this carries implications for the dollar, for interest rates and for the value of all sorts of different dollar-based assets.

There's an overwhelming consensus that the dollar will weaken further this year. The problem, however, lies in spelling out fully the implications of a dollar decline. Which currencies will rise against the dollar? To what extent could the US use protectionist threats to force greater flexibility in currencies that, to date, have kept their pegs against the dollar? Would a dollar decline ultimately unsettle the stability of the US Treasury market, pointing to significantly higher bond yields? What would happen to equity values when faced with a higher-risk premium? What would be the best hedge against the dollar? Perhaps it is the euro, but maybe it is commodities that are priced in dollars but which will rise in value should the dollar soften.

A second threat comes from global political change. The West takes comfort in the view that, given the choice, countries will always opt for democracy. Ukraine's experience supports this view, and maybe the elections in Iraq might lend credence too. But Russia's democratic traditions are fairly odd by Western standards - autocracy never seems far away - and there is no guarantee that a democratic process in the Middle East would not simply deliver theocracies rather than liberal democracies.

What would happen were relationships between Russia, the Middle East and the West to come under mounting strain? The most obvious implication would be further instability in oil prices. Think of a world where oil prices were to rise still further, perhaps up to $80 a barrel. Headline inflation might be a little higher but I suspect the real damage would be seen through lower growth, squeezed profits and higher unemployment.

A third threat comes from house prices. Everyone knows that the UK housing market is not quite the beacon of strength it once was. And the debate over how far house prices could fall in 2005 continues to be a major topic of discussion.

What is less clear is the impact of falling house prices on broader economic activity. The Bank of England's view is that there is little relationship these days between house prices and consumer spending. The Monetary Policy Committee claims that income and consumption have grown in line, thereby suggesting that house prices have played only a small part in supporting demand growth.

I am not comfortable with this view: mortgage equity withdrawal has been buoyant, suggesting that, in the absence of house price inflation, consumer spending might have been a lot less resilient than it has been. Perhaps 2005 may finally be the year when we discover the true relationship between house prices and consumer spending. If the relationship proves to be closer than the Bank thinks, we arelikely to see both base rate cuts and, eventually, a lower level for sterling against the euro and, possibly, against the dollar. Throw in a bit of post-election political uncertainty - strains between numbers 10 and 11 - and maybe we will end up with a good old-fashioned sterling crisis.

A fourth risk comes from productivity. This time, however, the news may prove to be rather good. If there has been a surprise in recent years, it has been the split between growth and inflation, most obviously in the US but, more recently, in the UK. For a given growth rate, inflation has been lower than expected or, put another way, for a given inflation rate, growth has been higher than expected.

Why has this happened? Primarily, it seems, because of supply-side improvements. Some of these may reflect changes within the labour market but, increasingly, it seems likely that the introduction of new technologies is creating another productivity wave that may have raised the UK economy's speed limit. Certainly, an improvement of this kind would go some way to explaining why the Monetary Policy Committee has persistently undershot its inflation target.

A fifth risk relates to policy regimes. This risk is a bit like a slow burning fuse: we are not likely to know the answer until well beyond 2005. But suppose that the housing market does go wrong in the UK. Suppose, also, that the growing US current account deficit leads to problems for American asset prices - equities, housing - in the light of a persistently weak dollar. Let us say that, in both countries, demand unexpectedly weakens: suddenly people start to worry about the possibility of economic downswings, possibly even outright recessions. What would this tell us about the policy framework?

Presumably, developments along these lines would suggest that inflation targeting regimes, on their own, do not provide a lasting guarantee of macroeconomic stability. Remember, it was only because the Bank of England and Federal Reserve adhered to their inflation targets, and because the UK and US governments loosened fiscal policy, that we had a combination of rapidly rising house prices and widening current account deficits in the first place.

If it turns out that these factors are new sources of instability, it becomes increasingly difficult to argue that simple inflation targeting regimes are the answer to all macroeconomic problems. Perhaps a reassessment will be prompted, with central banks and governments forced to reflect on what went wrong. After all, experience suggests that any policy regime will eventually break down - think of the full employment policies of the 1960s or the monetary targeting regimes of the 1980s.

To sum up, I would say that most of the threats to the economic outlook in 2005 are fairly familiar - a weak dollar, lower house prices, a productivity miracle. The consequences of these threats, however, are a lot less obvious and it is in these areas that the hot debates will be maintained throughout much of the year.